The current inflation target
2.0% on average
why is the target positive?
On 10 December 2003, the Chancellor announced that the new
inflation target would be 2.0%, based on the HICP measure, which
was renamed the Consumer Prices Index (CPI). Like the RPIX target,
the new target is symmetrical.
Differences in the way the CPI is constructed mean the
rate of increase of prices across the economy is lower using
the CPI measure than the RPIX measure. And so the equivalent
inflation target using CPI is lower than the RPIX target. The
main differences between RPIX and CPI are explained in the box
at the end of this section. The remainder of this section
contains some general points about the inflation target.
2.0% on average 
Having a target for annual inflation of 2.0% does not mean
that the Monetary Policy Committee is expected to hold inflation
at 2.0% all the time. That would not be possible or, in fact,
desirable. Inflation might change month to month for all kinds
of reasons, many of which will only have a temporary influence.
stormy weather...
The inflation rate might change, for example, because of the
weather. If there had been a very wet or very dry summer, we
might expect this to result in bad food harvests. Any resultant
fall in the supply of food might push some food prices higher
for a time, and raise the overall inflation rate. But we would
not expect interest rates to be changed because of this.
We do not want to force changes in demand and output across
the economy to get inflation back to 2.0% every time it moves
higher or lower. That would mean interest rates going up and
down all the time. This would create great uncertainty and unnecessary
volatility in the economy. And, by the time the effects had
worked through the economy, inflation might well have changed
again for another reason. Remember, when interest rates are
changed, there is little immediate effect on inflation. It takes
time.
monetary policy is aiming to ensure that the inflation rate
is 2.0% on average over time
So we accept that the inflation rate will move up and down
because the economy is subject to all sorts of influences and
unexpected events. The aim is to set interest rates at a level
that we think gives the best chance of inflation being 2.0%
in around two years' time. But we know it will not always be
exactly that rate. When inflation does change, we need to understand
why and assess whether the change is likely to persist or if
the reasons for the change are likely to have a broader impact
on the economy and future inflation. But we do not need to change
interest rates every time this happens. In this sense, monetary
policy is aiming to ensure the inflation rate is 2.0% on average
over time.
why is the target positive?
why not have an inflation target of 0%?
Although the objective of stable prices actually means no inflation,
we do not aim for this. We prefer to have a moderate amount
of inflation rather than zero inflation. There are a number
of reasons for this, although economists debate which matter
most.
having a positive inflation target allows real interest rates
to be negative which might be a useful policy option when demand
is weak
One consideration concerns the fact that interest rates cannot
fall below zero - banks cannot charge negative interest rates.
But what we call real interest rates - the interest rate minus
the inflation rate - can be, and often are, negative. That is
simply when the rate of inflation is higher than the actual
rate of interest. We call the actual rate of interest - ie what
is paid in money terms - the nominal interest rate.
When real interest rates are negative, there is a big incentive
for people to spend and borrow rather than save. One hundred
pounds might earn 5% interest if it was put in a bank account
for a year. But if the inflation rate is 10% in that year, the
cash will be worth less in a year's time than it is now. The
real rate of interest is minus 5%. In this situation, people
are likely to prefer to spend more today rather than tomorrow.
Having negative real interest rates - when the nominal rate
of interest is below the rate of inflation - might be a useful
policy option if demand in the economy is very weak, such as
during a recession. However, if we have zero inflation, then
the policy option of having negative real interest rates is
lost. Like nominal interest rates, real rates could not be lower
than zero. Retaining this policy option is often cited as one
of the reasons for having an inflation target above zero.
Another reason that we do not have a target of zero inflation
relates to our ability to measure inflation accurately. It is
not possible or practical to record every single price in the
country every day of the week. So we have to estimate inflation
by taking a sample of prices. This sample tries to be representative
but it is only ever an approximation of what people are spending
their money on and what prices they are paying.
It is generally recognised that the true level of inflation
is usually below the rate of inflation recorded by a measure
like the CPI - it overstates inflation to a small degree.
the measured rate of inflation tends to overstate the true
inflation rate
Some price increases will reflect improvements in quality.
For example, computers might include more features or have faster
processors; cars might be more reliable. So, from year to year,
prices might not be measured on an identical like-for-like basis.
It is difficult to incorporate quality improvements in a price
index although some adjustments can be made. But we need to
acknowledge that some price increases will be due to quality
improvements - in other words, consumers are getting more for
their money.
Because of this and other reasons, the measured rate of inflation
tends to overstate the true rate of inflation to a small degree.
So if we had a zero inflation target, we would be targeting
falling prices. A general fall in prices - what we call deflation
- could cause demand to fall if people expect prices to be lower
in the future and consequently decide to delay their spending.
why not have an inflation target of 5% or 10%?
Many of the costs of inflation are associated with its unpredictability.
But if we could be sure that inflation could be held at 5% or
10% a year, then the costs of higher inflation might not be
as great. However, it would be odd to be using money as a standard
measure of value for goods and services if its value was going
to decline by 5% or 10% every year. We would continually have
to adjust the value of everything by 5% or 10%. Because having
higher inflation would bring no lasting benefit - in terms of
output and employment - we would have to ask why not aim for
something lower, which was more consistent with stable prices?
In practice, the higher inflation is, the more uncertain and
volatile it tends to be. Having high and stable inflation might
not be an option.
RPIX and CPI
The RPIX and CPI both provide a measure of the changes
in the cost of purchasing a representative basket of goods and
services. Although they both use broadly the same price information,
there are key differences between them.
composition
The prices of some goods and services are included in one
index but not the other, or are treated differently in the two
indices. For instance, RPIX includes a measure of owner-occupied
housing costs, buildings insurance and Council Tax, all of which
are currently excluded from the CPI. Together, these costs account
for around 9% of the RPIX basket of goods and services. Some
goods and services appear in both baskets but are measured in
different ways. Cars are an example - the RPIX uses only second-hand
car prices, while the CPI uses new and second-hand prices.
coverage
In order to make the chosen basket of goods and services closer
to that of an 'average' UK household, the RPIX excludes expenditure
by the highest 4% of earners, pensioners largely on benefits,
and residents of institutions. The CPI includes the expenditure
of all private households and residents, as well as foreign
visitors to the UK, so takes account of spending by all consumers.
combining prices
For around 40% of the goods and services in the RPIX and CPI,
the raw prices are weighted together according to the expenditure
patterns of UK households, as we described in the What
is Inflation? section. But for the other 60% of goods and
services, expenditure weights are not available at a sufficiently
low level of disaggregation to be able to do this. So, as an
initial step, the raw prices have to be combined in some way
to obtain an average price that is broadly equivalent to the
categories of expenditure for which weights are available. The
RPI and CPI use different averaging methods to do this. You
don't need to know the details but if you are interested, these
are explained in the May
2003 and February
2004 Inflation Reports.
The
May 2003 Inflation Report refers to the HICP (Harmonised
Index of Consumer Prices) measure of inflation. The HCIP was
renamed to CPI in December 2003.
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